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CHINA'S SOLAR-POWER STOCKS WERE a red-hot bubble until Wednesday. That's when investors learned that an accounting officer had quit one of the industry's hottest firms, the silicon-wafer maker
LDK Solar
(ticker: LDK), while alleging that LDK's warehouse and financial reports were loaded with junk. As its American depositary shares fell by nearly 30%, LDK defended its bookkeeping and assured shareholders that it has more than 1,000 metric tons of silicon material.

There may be good stuff in that pile of silicon, but that doesn't mean it's worth what LDK's balance sheet says. On Sept. 25, the Xinyu City, China, firm's financial controller, Charley Situ, sent e-mails to regulators, auditors and investment bankers saying that he had quit because his bosses refused to write off bad inventory. His allegations were disclosed, and largely dismissed, in a Wednesday note by LDK investment banker Piper Jaffray. Still, the news sent LDK's depositary shares reeling, from over $71 to 50.95 by Friday.

Even after that sickening dive, LDK's New York-listed shares go for nine times book value and over 40 times this year's forecast earnings-so investors should still care if the book value, and therefore its profit, is overstated. The inventory that makes up that book value may warrant concern. With the help of an interpreter, Barron's talked to someone with knowledge of LDK's manufacturing. That person said that the company's silicon ingots were indeed so impure that a recent production run had produced tons of them that were too contaminated for technicians to even analyze with instruments. The company says it knows of no such problems.

LDK isn't the only producer of solar silicon in China that uses low-paid workers to sort through scrap in search of some good enough to be melted into solar-cell wafers. Nor is it the only one with a high-priced stock, as you can see in the table. Investors in China and the U.S. have rushed into China's solar-cell stocks as rashly as investors jumped onto the Internet in the 1990s.

With help from China's government, its bankers and U.S. underwriters, green fields have sprouted silicon-wafer factories built by businessmen with expertise seemingly as unrelated to silicon as aluminum siding and safety shoes. Even if financial and manufacturing controls prove to be no problem, competition will. LDK still enjoyed a market capitalization of $5 billion last week, but a couple of hundred million dollars in machinery is enough to reproduce its business anywhere in the world, and dozens of firms in China and elsewhere have been buying wafer-making gear from LDK's vendors. All you need is cheap labor, friendly bankers and a willingness to stomach negative free-cash flow.

But a shortage of refined polysilicon has pinched solar-cell makers in the past few years. The raw material's price has gone from around $30 a kilogram to over $250 on the spot market, creating a windfall for producers like
MEMC Electronic Materials
(WFR). But the higher prices have hurt China's latest solar-cell contenders, which lack established supplier relationships-which helps explain the net losses at China-based Canadian Solar (CSIQ).

So firms like LDK and London-listed ReneSola (SOLA.UK) have developed recipes that use large portions of recycled silicon. LDK has more than 3,000 workers sorting and testing scrap the company obtains from broken wafers, semiconductor rejects and ingot sawdust. LDK brags that its secret recipe lets it make wafers with as little as 25% virgin polysilicon. Since silicon accounts for 75% of LDK's cost-of-goods-sold, the potential savings are a big deal.

And LDK's industry-leading profit margin of 29% would seem to validate the savings from the company's scrap recipe. But those savings may be a mirage, according to the allegations of ex-controller Situ and a person familiar with LDK's manufacturing.

Via a translator, Barron's learned that LDK's furnaces are often short of usable feedstock, even though the company's piles of silicon scrap keep growing. The factory's internal information is unreliable, with one record reportedly indicating that LDK's wafer-cutting saws had an impossible yield of 140%. Industry experts say that most wafer-cutting enterprises break even at 90% usable yields. Instead, according to the person knowledgeable about the manufacturing, LDK's wafering operation has yields that actually range from 55% to 70%. The company won't comment on its yields.

Low yields from LDK's production may stem from its practice of buying just about any scrap that has silicon in it, says this same person. Several months back, the company's furnaces produced a batch of several dozen 270-kilo ingots so motley that testing instruments couldn't even tell whether the resulting silicon was positively or negatively charged. The virgin-silicon supplier MEMC was so alarmed at the quality of wafers produced by LDK, says the source, that it stationed its own quality-control monitor at the LDK factory in China's Jiangxi province.

LDK's Chief Financial Officer Jack Lai says he knows nothing of such manufacturing problems and insists that the company is making its deliveries on time to satisfied customers. He says the company fired Situ, the controller, for absenteeism after Situ didn't come to work for eight days. Lai says he never saw a Sept. 25 resignation e-mail that Situ addressed to him and copied to the SEC (and many others).

The Bottom Line

LDK Solar still looks expensive in light of questions about its accounting for inventory and therefore profits. The shares, already off sharply, could keep heading toward zero.

In his resignation letter, Situ said that LDK's inventories might be overvalued by $46 million to $92 million, which is more than the company reported in profits before its May 31 initial offering in the U.S. E-mail discussions that started before the May IPO show Situ trying to get colleagues to reconcile discrepancies between LDK's accounting ledger and its warehouse ledger. A spreadsheet circulated by Situ showed that by the end of August, LDK warehouse records listed about $54 million worth of silicon feedstock, but accounting records showed $100 million.

Through August, according to Situ's spreadsheet, LDK sank about $119 million of cash into inventory. LDK's Jack Lai says that Situ's numbers are wrong.

Situ's internal campaign ended on Sept. 13, when financial chief Lai held a conference call with him and other accounting staff. Situ argued that LDK should take a charge for its unusable silicon scrap. In a subsequent statement, Situ says the conference ended when he was overruled by the company's chief accounting officer, Qiqiang Yao. The ruling: Silicon scrap that was not usable today might someday become usable with the new processing techniques.

That sounds like a judgment on a par with the decision to freeze Ted Williams' head, in hope that future medical miracles might someday revive the Red Sox legend.

Situ says he quit after that decision, not wanting to be party to what he considers a stock fraud. Finance chief Lai says that Situ just didn't understand the silicon-wafering business. In a Thursday press release, LDK says that a management team took a physical inventory of polysilicon feed stocks and found no accounting discrepancies. When LDK's auditors at KPMG complete an independent investigation, the company says it will disclose the results.

Financial chief Lai points to hundreds of millions in sales agreements announced in the last few months. Of course, every firm in the solar-cell industry has been announcing sales deals. That's because companies are double- and triple-ordering, to combat the shortage of good silicon.

Despite LDK's controversy, China's solar stocks ended last week with their handsome valuations largely intact. That's in part because investment bankers like Piper Jaffrey stubbornly maintained their Outperform ratings, even as they circulated Charley Situ's e-mails to institutional investors. Sound familiar? That's how analysts like Henry Blodget behaved before the bursting of the Internet bubble.